Why macroprudential regulation?

With the RBNZ asking for comments on the upcoming countercyclical capital adequacy  regulation, and the RBA/APRA releasing a report on macroprudential policy now is a good time to ask – why?

I have seen many people justify these types of policies based on “debt being high” – but this doesn’t answer “why”.  I’ve heard a large number of people say it is because government savings made the private sector borrow, leading to financial instability – this not only doesn’t answer why, but it doesn’t involve any sort of sensible role for private agents and so is incoherent.

However, economists aren’t keen to let this issue slide – thank goodness!  The key concern, as previously mentioned, is trying to figure out what the market failure involved is.  What factors drive the systemic risk in the financial sector?  One interesting approach to microfound the incentives through the cycle that lead to this market failure is found here – one I found interesting at least, as there are many more 🙂

Now, it is useful to ask why for a couple of reasons:

1. We can explain why these policies are actually a good idea – remember, just because something is volatile doesn’t make it bad instead we have to explain why to understand it in this sense.
2. We can understand the impact of the policies – remember that it is likely that some financial regulation will involve a trade-off between output and stability.  When that is the case, we want to actually decide whether this trade-off is worthwhile.

If we can answer these, we can put in place good policy, policy we can explain, with impacts we can describe, and outcomes we can understand (and hopefully anticipate).